The perfect family vehicle

The wish to pass on unused wealth to family is a strong motivation for many people.

That’s why Inheritance Tax (IHT) has such a high public profile, despite raising relatively small amounts of tax for the government.

The desire to pass on pension wealth is no different, and pensions had the similarly reviled 82% tax charge for those wanting to pass on lump sums if they died after age 75.

As part of the widespread retirement changes introduced in April, this tax charge has been much reduced.

So are pensions now the ideal estate planning vehicle?

Previously, there was a three-tier tax structure for lump sum death benefits. If the individual died before age 75 and had not touched their pension fund, a tax-free lump sum was paid.

However, there were certain situations where an IHT charge could arise, especially if HM Revenue and Customs believed people in serious ill-health were deliberately delaying taking benefits to increase the amount paid to their family.

Deaths in drawdown before age 75, saw the government take 35% of the fund, while people who made it into alternatively secured pension (ASP) and died after age 75 could be hit by the extreme 82% tax charge.

In practice this rarely happened as ASP providers would not allow lump sums to be paid, other than to charity, as they did not want to risk their entire scheme being hit by unauthorised payment charges or even be de-registered.

The coalition government’s changes essentially remove IHT from the equation. Now a two-tier structure exists  a tax-free lump sum if benefits have not been touched and death is before age 75, and a 55% tax charge once money is in drawdown, or after age 75 in any case.

So while the relevance of age 75 has been removed in many instances, it is still important for death benefits.

How will behaviour change?

These changes are likely to change behaviour in a number of ways. Previously, around half of people entering drawdown took their tax-free lump sum but chose to take no income.

While the majority of people entering drawdown are likely to survive beyond age 75, the fact that more than half of the fund will disappear if a lump sum death benefit is paid needs to be taken into account in any decision.

Allowing the partner, if there is one, to continue to take an income from the drawdown may be an option.

But this is only likely to be possible if appropriate paperwork is completed before the member’s death. The default option is usually the payment of a lump sum.

For new clients moving into drawdown, the change to death benefits can be taken into account as part of the advice process.

However, it is also important that clients already in drawdown understand the implications of the tax increase if they die after 75, and consider if drawdown is still the most suitable option, taking into account their state of health and other personal circumstances.

The reduction of the tax charge after age 75 allows people to use pensions as an estate planning vehicle in future.

But is this the best option, or are there other alternatives which provide a better outcome? The answer, as always with pension tax, is not straightforward, but depends on the interaction of income tax and IHT as illustrated in the table below.

Assuming death takes place after age 75, any fund remaining in the pension is taxed at 55%, although no IHT is due.

In contrast, if income can be withdrawn from the pension and sheltered from IHT less tax is due. It is particularly attractive if withdrawals are liable to 20% or 40% income tax (or some combination of the two), as the tax bill can be less than half that levied on the pension fund.

Mitigating IHT

However the position is substantially different if the individual withdraws income from the pension, and it is part of their inheritable estate on death.

In this situation, the total tax bill can reach 70%, not far off the much-maligned ASP charge.

While minimising income tax is important, these figures show the key factor is ensuring any withdrawals are not liable to IHT when the member dies.

If IHT can be avoided, withdrawing income from the pension looks to be the optimum solution; otherwise it is likely to be best to leave un-needed funds in the pension pot.

Financial advisers are in the prime position to help clients make sure any income withdrawn is sheltered from IHT. There are a variety of solutions available.

The client could simply spend the extra income, taking extra holidays or paying school fees for grandchildren.

Another straightforward option is gifting excess income to family members, although people will often need help in maximising gifts within the IHT rules. More complex solutions involve placing money into a suitable trust, or paying third party pension contributions for children or grandchildren.